Trump and the Republicans have broken the connection between strong economies and lower budget deficits

Jared Bernstein, a former chief economist to Vice President Joe Biden, is a senior fellow at the Center on Budget and Policy Priorities and author of 'The Reconnection Agenda: Reuniting Growth and Prosperity'.

October 17, 2018

Although this outcome was fully expected, there’s been considerable attention paid to new reports that the Trump administration’s budget deficit for fiscal 2018 is $779 billion, or just under 4 percent of GDP. That’s a 17 percent jump over the prior year’s level and a particularly large deficit considering the strong underlying conditions in the U.S. economy. What follows is my take on why the deficit is worsening, why it’s important and what should be done about it.

Telegraphing my punchline, President Trump and the Republicans have, with their tax cut, broken a key fiscal function in the American economy: When we close on full economic capacity, as is currently the case, tax revenues as a share of the economy should significantly rise, and deficits should fall. Instead, revenues have come way down, and deficits have climbed.

Why is the deficit 17 percent higher than last year, especially when the economy is growing faster, and unemployment is lower?

It’s primarily because the tax cuts have significantly reduced the amount of federal tax revenue the economy will spin off for any given growth rate. Increased spending also played a role but not as large a one as the tax cuts. If this sounds out of sync with Republican claims that “tax cuts will pay for themselves,” that’s because it is. They don’t … never did … never will.

Consider these numbers. Using data back to the mid-1940s, I calculated the average deficit as a share of GDP over every year since the late 1940s that the unemployment rate was lower than or equal to 4.5 percent (it’s currently 3.7 percent). That average is -0.4 percent, as opposed to the -3.9 percent noted above for 2018. By the way, if I take this and last year’s deficit (-3.5 percent) out of that average, the result is a small surplus (0.1 percent).

This figure below shows this heretofore tight correlation between deficit and unemployment rate. To make the relationship easier to see, I’ve inverted the unemployment rate, so e.g., 4 becomes -4. When the economy tightened up, deficits used to come down. But the circled area at the end of the figure shows that under today’s fiscal policy that is no longer the case.

Revealingly, in both fiscal 2000 and 2018, the unemployment rate was 4 percent. As the next figure shows, in 2000, the strong economy teamed up with the structure of the tax code to deliver 20 percent of GDP in revenues to the Treasury. This year, that share fell to 16.5 percent.

Source: My analysis of OMB data. (Jared Bernstein/Jared Bernstein)

Advocates of the tax cuts will point to the difference in the spending bars between the two years, but here’s where the “baseline" — expected spending before the tax cut — comes into play. The Congressional Budget Office projected in the summer of 2017, before the tax cuts and this year’s spending deal, that we’d spend 20.5 percent of GDP this year, almost exactly the right number (20.3 percent). But CBO also thought — remember, this is pre-tax-cut — we’d collect 17.7 percent of GDP in revs when the actual was, as shown, 16.5 percent. This diminished revenue figure is the key difference between what CBO expected then and what occurred.

Why does this matter?

Based on our aging demographics alone, we’ve long known that we will need more revenue over the next decade, not less. Add in geopolitical threats, climate change and the damage from increasingly intense storms (which is tied to the warmer climate), infrastructure, the need to push back on poverty and inequality, counter-cyclical fiscal policy that will be needed for the next downturn, and, it’s not hard to understand why a rising deficit at full economic capacity is so ill-advised. That is, unless you’re being paid not to understand these fiscal realities.

What should be done about it?

Like everything else in this post, this too couldn’t be more obvious. We must close the loopholes introduced and widened by the Trump tax cuts and claw back the lost revenue. The recent revelations about Trump’s tax fraud mean we must fully fund the IRS to collect what’s owed. As I noted in my post on the Trump family’s tax evasion, every extra dollar we spend on enforcing the tax code raises $18 in new revenues. We should also look for reasonable savings on the spending side, but only those that hold harmless economically vulnerable families.

Predictably, even when confronted with evidence that the tax cuts are clearly failing to “pay for themselves,” administration officials doubled down. Treasury Secretary Mnuchin claimed that “the president’s economic policies that have stimulated strong economic growth, combined with proposals to cut wasteful spending, will lead America toward a sustainable financial path.” To be clear, “wasteful spending” for this crowd means pretty much anything other than defense. It especially means social insurance and safety net programs.

We now have clear evidence of the fiscal folly of Mnuchin et al.’s magical thinking. The red ink we learned about this week is merely the beginning of a red tide that will only, absent corrective action, get larger. Woe betide us if we fail to act.